Overhead Cost Computation and Control

By Sudha Agarwal
Chartered Accountant

Contents - Overhead Cost

Meaning and Introduction Overhead Accounting A) Collection, Classification and Codification of Overheads B) Allocation, Apportionment and Reapportionment of overheads C) Absorption of Overheads Under/Over Absorption of Overheads Administration Overheads Selling and Distribution Overheads Treatment of Other expenses

Meaning and Introduction

Overhead Accounting

The ultimate aim of overhead accounting is to absorb them in the product units produced by the firm. Absorption of overhead means charging each unit of a product with an equitable share of overhead expenses. In other words, as overheads are all indirect costs, it becomes dif. cult to charge them to the product units. In view of this, it becomes necessary to charge them to the product units on some equitably basis which is called as Absorption of overheads. The important steps involved in overhead accounting are as follows. A) Collection, Classification and Codification of Overheads B) Allocation, Apportionment and Reapportionment of overheads C) Absorption of Overheads.

A) Collection, Classification and Codification of Overheads

I. Collection of Overheads :- Overheads collection is the process of recording each item of cost in the records maintained for the purpose of ascertainment of cost of each cost center or unit. The following are the source documents for collection of overheads. i. Stores Requisition ii. Wages Sheet iii. Cash Book iv. Purchase Orders and Invoices v. Journal Entries vi. Other Registers and Records

A) Collection, Classification and Codification of Overheads

II. Classification of Overheads :- Classification is defined by CIMA as, the arrangement of items in logical groups having regard to their nature ( subjective classification ) or the purpose to be fulfilled. ( Objective classification) Classification is made according to following basis. i. Classification according to Elements :- According to this classification overheads are divided according to their elements. The classification is done as per the following details. - Indirect Materials :- Materials which cannot be identified with the given product unit of cost center is called as indirect materials. For example, lubricants used in a machine is an indirect material, similarly thread used to stitch clothes is also indirect material. Small nuts and bolts are also examples of indirect materials. - Indirect Labor :- Wages and salaries paid to indirect workers, i.e. workers who are not directly engaged on the production are examples of indirect wages. - Indirect Expenses :- Expenses such as rent and taxes, printing and stationery, power, insurance, electricity, marketing and selling expenses etc are the examples of indirect expenses.

A) Collection, Classification and Codification of Overheads

ii. Functional Classification :- Overheads can also be classified according to their functions. This classification is done as given below. - Manufacturing Overheads :- Indirect expenses incurred for manufacturing are called as manufacturing overheads. For example, factory power, works managers salary, factory insurance, depreciation of factory machinery and other fixed assets, indirect materials used in production etc. - Administrative Overheads :- Indirect expenses incurred for running the administration are known as Administrative Overheads. Examples of such overheads are, office salaries, printing and stationery, office telephone, office rent, electricity used in the office, salaries of administrative staff etc. - Selling and Distribution Overheads :- Overheads incurred for getting orders from consumers are called as selling overheads. On the other hand, overheads incurred for execution of order are called as distribution overheads. Examples of selling overheads are, sales promotion expenses, marketing expenses, salesmens salaries and commission, advertising expenses etc. Examples of distribution overheads are warehouse charges, transportation of outgoing goods, packing, commission of middlemen etc. - Research and Development Overheads :- In the modern days, firms spend heavily on research and development. Expenses incurred on research and development are known as Research and Development overheads.

A) Collection, Classification and Codification of Overheads

iii. Classification according to Behavior :- According to this classification, overheads are classified as fixed, variable and semi-variable. - Fixed Overheads :- Fixed overheads are commonly described as those that do not vary in total amount with increase or decrease in production volume, for a given period of time, may be a year. Salaries, depreciation of fixed assets, property taxes, are some of the examples of fixed costs. Total fixed costs remain same irrespective of changes in volume of production but per unit of fixed cost is variable. It increases if production decreases while if production increases, it decreases. - Variable Overheads :- Variable overheads are those which go on increasing if production volume increases and go on decreasing if the volume decreases. Such increase or decrease may or may not be in the same proportion. Variable overheads are generally considered to be controllable as they are directly connected with the production. - Semi-variable Overheads :- These types of overheads remain constant over a relatively short range of variation in output and then are abruptly changed to a new level. For example, supervisors salary is treated as fixed but if a decision is taken to operate a second shift, additional supervisor may have to be appointed which results into increase in the salary of the supervisor. This indicates that it is a semi-variable overheads. Similarly, maintenance expenditure, fire insurance are also semi-variable overheads. III. Codification of Overheads :helps in easy identification of different items of overheads. There are numerous items of overheads and a code number to each one will facilitate identification of these items easily. done by allotting numerical codes or alphabetical codes or a combination of both.

B) Allocation, Apportionment and Reapportionment of Overheads

The following steps are required to complete this process. Departmentalization :Means creating departments in the firm so that the overhead expenses can be conveniently allocated or apportioned to these departments. For efficient working and to facilitate the process of allocation, apportionment and reapportionment process, an organization is divided into number of departments like, machining, personnel, fabrication, assembling, maintenance, power, tool room, stores, accounts, costing etc and the overheads are collected, allocated or apportioned to these departments. This process is known as departmentalization of overheads which will help in ascertainment of cost of each department and control of expenses. Allocation :the charging of discrete, identifiable items of cost to cost centers or cost units. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identified, salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division. Thus allocation is a direct process of identifying overheads to the cost units or cost center.

B) Allocation, Apportionment and Reapportionment of Overheads

Apportionment :if it is not possible to charge the overheads to a particular cost center or cost unit, they are to be apportioned to various departments on some suitable basis. For example, if separate meters are provided in each department, the electricity expenses can be allocated to various departments. However if separate meters are not provided, electricity expenses will have to be apportioned to the departments on some suitable basis like number of light points. Similarly rent will have to be apportioned to various departments on the basis of floor space, insurance of machinery on the basis of value of machinery, power on the basis of horsepower etc A statement showing the apportionment of overheads is called as Primary Distribution Summary of overheads.

B) Allocation, Apportionment and Reapportionment of Overheads

Reapportionment of Overheads :The departments are broadly divided into Production Departments and Service Departments. In Primary Distribution Summary, the overheads are apportioned to all the Departments, i.e. Production and Service. For the purpose of absorption it is necessary that the overheads of the service departments are reapportioned to the production departments. This process is called as preparation of Secondary Distribution Summary of overheads. Suppose, there are five departments in a manufacturing firm, P1, P2, and P3 are the production departments and S1 and S2 are the service departments. The following results are available from the Primary Distribution Summary. In the secondary distribution summary, the overheads of S1 and S2 will have to be charged to Production Departments, P1, P2, and P3. This will have to be done on some suitable basis. The matter becomes complicated if S1 and S2 are rendering services to each other in addition to the services rendered to the production departments. The methods of reapportionment are divided into two types.

B) Allocation, Apportionment and Reapportionment of Overheads

Non Reciprocal Methods :- Under this method, the assumption is that while service departments render services to the production departments, they do not render services to each other. Hence their overheads are not apportioned to each other. The following methods are used under non reciprocal methods - Services Rendered :- A production department which receives maximum services from service departments should be charged with the largest share of the overheads. - Ability to Pay :- This method suggests that a large share of service departments overhead costs should be assigned to those producing departments whose product contribute the most to the income of the business firm. - Survey or analysis Method :- This method is used where a suitable base is difficult to find. For example, the postage cost could be apportioned on a survey of postage used during a year

B) Allocation, Apportionment and Reapportionment of Overheads

Reciprocal Method :- Under this method, the assumption is that the service departments do render services to the production departments, they also render services to other service departments. - Repeated Distribution Method:- Under this method, services rendered by services departments to the production departments and other services departments are quantified in the form of percentages. The services departments costs are reapportioned to the production departments on the basis of these percentages. The process is repeated again and again till a negligible figure is reached. This method becomes complicated for calculation if the figures are too large. - Simultaneous Equation Method :- This is an algebraic method in which simultaneous equations are formed and amount of overhead expenses of each service department are found out, by solving the equations.

C) Absorption of Overheads

the process of absorbing all overhead costs allocated or apportioned over a particular cost center or production department by the units produced. absorption means charging equitable share of overhead expenses to the products. the basis is the absorption rate which is calculated by dividing the overhead expenses by the base selected. The formula used for deciding the rate is as follows, Overhead Absorption Rate = Overhead Expenses/ Units of the base selected.

C) Absorption of Overheads
The

methods used for absorption are as follows. Direct Material Cost :- Under this method, the overheads are absorbed on the basis of percentage of direct material cost. Budgeted or Actual Overhead Cost/ Direct Material Cost *100 Thus if the overhead expenses are Rs. 2,00,000 and Direct Material Cost is Rs. 4,00,000 the percentage of overheads to direct material cost will be, 2,00,000/4,00,000 X 100 = 50%. Overheads will be thus absorbed on the basis of percentage of 50% to material costs.

C) Absorption of Overheads

Illustration :- A firm produces two products, A and B. Direct material costs for A are Rs. 2,50,000 and for B, Rs. 1,50,000. The overheads will be charged to these products as shown in the following statement, assuming the rate of absorption as 50% Particulars Product A Product B Direct Materials 2,50,000 1,50,000 Overheads 50% of Direct Materials 1,25,000 75,000 Total Materials + Overheads 3,75,000 2,25,000 This method is suitable in those organizations where material is a dominant factor in the total cost structure.

C) Absorption of Overheads

Direct Labor Cost Method :- This method is used in those organizations where labor is a dominant factor in the total cost. Budgeted or Actual Overheads/ Direct Labor Cost X 100 Thus if the overheads are Rs. 3,00,000 and Direct Labor Cost is Rs. 4,00,000 the % of absorption will be 3,00,000/4,00,000 100 = 75%. Overheads will be charged to each product as 75% of labor cost. This method is also simple to understand and easy to operate. However, it ignores the time taken by each worker for completion of the job. Similarly it ignores the work performed by machine where a labor is a mere attendant. Prime Cost Method :- the Prime Cost is taken as the base for calculating the percentage of absorption of overheads by using the following formula. Budgeted or Actual Overheads/ Prime Cost * 100

C) Absorption of Overheads

Illustration :- A manufacturing firm produces two products, A and B. The direct material cost for A is Rs. 5,00,000 and for B Rs. 3,00,000, direct labor cost is Rs. 3,00,000 and Rs. 2,00,000 respectively for A and B, direct expenses are Rs. 1,00,000 and Rs. 2,00,000 respectively for A and B. The overhead expenses are Rs. 9,60,000. The statement of cost will appear as follows. Note :- Overhead absorption rate is calculated as 9,60,000/16,00,000 * 100 = 60%

C) Absorption of Overheads

Production Unit Method :- This method is used when all production units are similar to each other in all respects. Total overhead expenses are divided by total production units for computing the rate per unit of overheads and overheads are absorbed in the product units. If a firm produces more than one product and if they are not uniform to each other, equivalent units are calculated to find out the rate of overheads per unit. Overhead absorption rate = Budgeted or Actual Overheads/Production Units Direct Labor Hour Method :- Under this method, the rate of absorption is calculated by dividing the overhead expenses by the direct labor hours. Budgeted or Actual Overhead Expenses/Direct Labor Hours This method takes into account the time spent by the labor in production of each unit where the production units are not uniform or identical. it is not suitable if the firm is capital intensive and highly mechanized.

C) Absorption of Overheads

Machine Hour Rate :- Where machines are more dominant than labor, machine hour rate method is used. actual or predetermined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost to be appropriated or absorbed by a number of hours for which a machine or machines are operated or expected to be operated. Budgeted or Actual Overhead Expenses/ Machine Hours Actual or Budgeted Selling Price Method :- In this method, selling price of the products is used as a basis for absorbing the overheads. The logic used is that if the selling price is high, the product should bear higher overhead cost. Ratio of selling price is worked out and the overheads are absorbed.

Under/Over Absorption of Overheads

Meaning :- a rate of absorption is computed and then the overheads are charged to the products. The rate of absorption may be either predetermined or historical. The main advantage of the historical rate is that there is no possibility of under/over absorption of overheads. If predetermined rate is used, there is every possibility of under or over absorption of overheads. Illustration :- A manufacturing company uses direct material cost as the basis for absorption of overheads. The absorption rate is worked out as follows. Budgeted Overheads Rs. 50,000/ Budgeted Material Cost Rs. 1,00,000 * 100 i.e. 50% Now if the actual overheads are Rs. 70,000 and the actual direct material cost is Rs. 1,20,000, the overheads absorbed will be Rs. 60,000 i.e. 50% of the direct material cost and there will be under absorption of Rs. 10,000 as the actual overheads incurred are Rs. 70,000.

Under/Over Absorption of Overheads

Once the under/over absorption is noticed, the following corrective steps are to be taken to rectify the same. Use of supplementary Rate :- The under/over absorption can be rectified by using the supplementary rate. This rate is calculated by dividing the under/over absorbed amount of overheads by the units of the base. The rate so arrived is known to be supplementary rate. Carrying forward to future period :- If the amount of under/over absorption of overheads is small, it may be carried forward to the future period hoping that it will be rectified in the future. Writing off to Profit and Loss A/c :- Amount of under/over absorption can be written off to Costing Profit and Loss Account and thus not reflected in the total costs.

Administration Overheads

1) Meaning Administration cost is the cost of running the administration of a firm. Examples of administrative overheads are, general office expenses, office salaries, printing and stationery, office lighting, audit fees, insurance of office equipments, depreciation of office equipments and building, rent, legal charges, repairs of office premises and machinery, traveling expenses of office staff etc. 2) Treatment in Cost Accounts: There are three methods of treatment of administrative overheads in cost accounts. I. Transfer to Costing Profit and Loss Account: Under this method, the administration overheads are treated as period costs and is written off to the Costing Profit and Loss Account. Thus these costs are not charged to jobs or production units as they are not directly related to the production. II. Apportionment to manufacturing and selling divisions: Under this method, administration overheads are divided between manufacturing and selling divisions on some suitable basis. The main logic behind this method is that, many experts believe that there are only two functions of a business firm and these are production and selling and other functions like administration are auxiliary functions.

Administration Overheads

Therefore the administration overheads should be merged with manufacturing and selling divisions. The ultimate effect of this method is that the administration overheads lose its identity. III. Separate functional element of cost: Under this method, administration overhead is considered as separate charge to the cost to make and sell. Accordingly, the cost of sales analysis sheet is prepared to show the manufacturing cost and is ultimately charged to the particular job or order. 3) Control of Administration Overheads: Administration overheads are mostly fixed in nature. They can also be termed as policy cost as they arise out of a policy. Due to these reasons, the administrative costs are fixed in nature and are uncontrollable. However control on these costs can be exercised through preparation of budgets and use of standard costing.

Selling and Distribution Overheads

1. Meaning: selling overheads are the overheads that are incurred for the selling efforts required for selling the product. While selling function aims at creating the demand, the distribution functions object is to execute the demand. Distribution overheads are the costs incurred for executing the orders received. Advertising expenses, sales promotion costs, salesmens salaries and commission, discounts offered are some of the examples of selling overheads. Warehouse rent, transportation, secondary packing are some of the examples of distribution costs. 2. Accounting of Selling and Distribution Overheads: The ultimate aim of accounting of selling and distribution overheads is to absorb them in the product units. Therefore they are allocated to the departments, territories, products etc to the extend possible. Wherever it is not possible to allocate them, they are apportioned on some suitable basis. After the apportionment, they are finally absorbed in the product

Selling and Distribution Overheads

The following are various methods of accounting of selling and distribution overheads. i. Sales service departments and territories: Selling and distribution costs are allocated to sales service departments and sales territories. Costs which cannot be allocated are apportioned to such departments by selecting some suitable basis like population coverage, net sales, sales quotas, floor space etc. help the organization to prepare a territory wise Profit and Loss Account by comparing the selling and distribution cost of each territory with the sales of each territory. ii. Salesmen wise analysis: This method is followed for evaluating the performance of salesmen. The selling and distribution cost is analyzed by salesmen to ascertain their comparative ability. Under this method, the selling and distribution costs are allocated to each salesman wherever possible.

Selling and Distribution Overheads

iii. Product wise analysis: Under this method, all the direct costs are charged directly to each product line. On the other hand, indirect costs are charged/apportioned to the products on some suitable basis like net sales or other suitable base. Decisions like closing an unprofitable line or further pushing a profitable product line can be taken on the basis of such analysis. iv. Sales order wise analysis: In this method, it is possible to find out the profit on sales order by charging all expenses to sales order. v. Other methods: In a departmental store, analysis of selling and distribution costs can be charged to each department so that it is possible to find out the profitability of each department. In retail establishments, if the management is interested in knowing the profitability of different lines of merchandise, costs can be allocated or apportioned to each line of merchandise like hardware, timber, coal, general merchandise, cosmetics, consumer durables, medicines etc.

Treatment of other Expenses

1. Inspection Charges: The inspection charges that can be identified with a product should be charged to that product. Inspection charges, which cannot be identified with a particular product should be treated as factory overheads and apportioned to production departments on some suitable basis like work done or inspection hours. 2. Design and Drawing Office Cost: These costs are treated as direct costs if they can be identified with a particular job or product. However if these costs cannot be identified with a particular job, they are charged to different jobs on some suitable basis like number of drawings made, chargeable man hours etc. Drawing to be enclosed with sales orders may be treated as administration overheads. 3. Carriage on Materials: Normally the carriage paid on incoming materials is treated as purchase cost. However if the carriage charges cover a large number of individual materials, it may be treated as an item of production overheads and spread over the different materials. Similarly material handling and storage expenses may be apportioned on the basis of value, weight, volume of materials or number of material requisitions.

Treatment of other Expenses

4. Canteen Expenses: Generally canteens in various firms are run on subsidized basis. In such case the costs are treated as an item of factory overheads and apportioned to different cost centers on suitable basis like number of employees, amount of wages, number of meals served etc. The canteen receipts are credited and net costs are apportioned. On the other hand, if the canteens are run on no profit no loss basis, the question of cost apportionment does not arise at all. 5. Training Costs: The costs incurred on training of employees are collected under different standing order numbers. The treatment of these costs depends on the amount of training expenses. If the amount is small or negligible, they are apportioned to different on suitable basis like number of employees trained. On the other hand, if the amount is heavy, training department is treated as a separate service center and then it is apportioned to other production and service departments on some suitable basis.

Treatment of other Expenses

6. Installation Cost of Plant and Machinery: When a new plant and machinery is installed, the cost of the installation of the same is capitalized and depreciation is charged as per the prescribed rates. 7. Set up Cost: This cost can be treated as a direct cost if it is for a particular job or production order. If it is a common cost which means that it is not possible to identify it with a particular job or production order, it is treated as production order and apportioned to different jobs on suitable basis like setting up time etc. 8. Dismantling Cost of Plant and Machinery: A plant and machinery may be dismantled due to sale as it may have become redundant or obsolete. This dismantling is permanent and hence the cost involved is added to the cost of asset dismantled and set off against any sale proceeds received on account of dismantling. On the other hand, if the dismantling is just for shifting the asset from one place to another, it may be treated as production overhead and apportioned/allocated to different cost centers.

Treatment of other Expenses

9. Compensatory Payment to Workers: Compensatory payment can be made regularly like gratuity. This will be treated as an item of overheads. If this payment is not of regular nature and is paid occasionally, the payment of compensation is estimated in advance and a proportionate amount is charged to overheads in each period on uniform basis. 10. Repairs and Maintenance Cost: Repairs and maintenance cost if paid as preventive maintenance is treated as overhead. The amount may be collected and charged to a separate department of Repairs and Maintenance. This department is treated as a separate service center and the amount is apportioned to other cost centers on some suitable basis. If repairs and maintenance is extremely heavy, it is capitalized and written off with the asset as depreciation. 11. Lighting, heating, ventilation, air-conditioning Expenses: This item is treated as an overhead and collected under a separate standing order number. If separate meters are installed in each department, this expenditure is allocated to various cost centers. On the other hand, if there are no separate meters, the amount is apportioned to various cost centers on some suitable basis like basis of wattage, number of electric points, floor area, cubic capacity, tonnage of air-conditioning, etc.

Treatment of other Expenses

12. Cost of Small Tools: One of the methods of treatment of the cost of small tools is to capitalize the cost and write off depreciation on the same. Depreciation is treated as an item of overheads. If there are any difficulties in treating this cost as a capital cost due to difficulty in ascertaining the life of small tools, the method followed is to charge the purchase price of small tools to a separate standing order number and distribute to other departments on some suitable basis and finally absorbed by products. 13. Medical Expenses: Cost of medical services are collected under separate standing order number and is apportioned to various cost centers on suitable basis like number of employees etc. If the amount spent is heavy, there may be a separate medical service department and the costs collected under that department. This amount is finally apportioned to other cost centers on suitable basis. 14. Royalties and Patent Fees: When royalties are paid for the right of use of patent process or component in the course of manufacturing, it is treated as production cost. On the other hand, if it is paid for use of right to sell, it is treated as selling overheads. When it is partially for production and partially for sale, the amount is apportioned between production and selling costs.

Treatment of other Expenses

15. Directors Fees and Salaries: This is part of administration overheads. However sometimes, this is apportioned between administration and selling and distribution overheads on the basis of time devoted. 16. Market Research: Market Research is an item of selling overhead as it is incurred for conducting study of market conditions and ascertainment of market potentiality. Cost of market research is apportioned to all the products produced by the firm if it is conducted for the entire organization. On the other hand, if it is incurred for a particular product, it may be treated as a direct charge for that product. 17. Bad Debts: Bad Debt is a selling overhead and included in the same. However abnormal bad debts are excluded from cost accounts. 18. Advertising Cost: Advertising expenditure incurred for a specific product is charged to that product. Cost of general advertisement is apportioned to different products on the basis of sales value. If the amount is heavy, the expenses may be treated as deferred revenue expenditure and can be charged in three or four years.

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